How Do Commercial Real Estate Loans Differ From Residential Loans?
It’s common knowledge that prospective homeowners typically seek out a mortgage loan to facilitate their property purchase.
But have you wondered how commercial real estate (CRE) is financed? There are some key differences between residential and commercial real estate mortgages. Before we get into the nitty-gritty, let’s first go over the basics of CRE.
What Is Considered Commercial Real Estate?
Non-living spaces like office buildings, warehouses, and any other business-related properties are considered to be commercial real estate. In other words, buildings that turn a profit through either rental income or capital gains are classified as non-residential real estate.
There are eight main categories of commercial real estate:
- Office spaces
- Industrial spaces
- Multi-family complexes
- Retail spaces
- Mixed-use properties
- Special-purpose (e.g., amusement parks, parking lots, theaters, zoos)
The property’s primary function (as defined by its purpose, occupancy, the length of its lease, and its associated rates) determines its category. According to Investopedia, these categories can be further specified: “Office space, for example, is often characterized as class A, class B, or class C.
- Class A represents the best buildings in terms of aesthetics, age, quality of infrastructure, and location.
- Class B buildings are usually older and not as competitive price-wise as class A buildings. Investors often target these buildings for restoration.
- Class C buildings are the oldest, usually over 20 years of age, located in less attractive areas, and in need of maintenance.
Note that some zoning and licensing authorities further break out industrial properties — sites used for the manufacture and production of goods, especially heavy goods — but most consider it a subset of commercial real estate.”
Now that you better understand what constitutes CRE, let’s dive into commercial real estate loans and how they work.
What Is a Commercial Real Estate Loan?
Some businesses own the space they occupy, but it’s more common for these buildings to be leased. Similar to mortgage loans for homes, banks and lenders are involved in originating loans for commercial real estate purchases. Banks and lenders aren’t the only ones providing capital for commercial real estate; insurance companies, pension funds, and private investors also provide capital in some situations.
Referring back to Investopedia, there are four types of commercial property leases, each requiring varying levels of responsibility from the landlord and tenant:
- “A single-net lease makes the tenant responsible for paying property taxes.
- A double-net (NN) lease makes the tenant responsible for paying property taxes and insurance.
- A triple-net (NNN) lease makes the tenant responsible for paying property taxes, insurance, and maintenance.
- Under a gross lease, the tenant pays only rent, and the landlord pays for the building’s property taxes, insurance, and maintenance.”
Key Differences Between Commercial and Residential Loans
While commercial and residential real estate loans function similarly, there are some key differences that set them apart.
Commercial Real Estate Loans
- These loans are often made to businesses, corporations, and companies.
- The loan term is typically between five and 20 years, but the amortization period can be longer than the loan term.
- The loan-to-value ratio for commercial loans usually falls between 65% - 80%.
Residential Real Estate Loans
- These loans (or mortgages) are often made to individual borrowers.
- The most common type of residential mortgage is the 30-year fixed-rate mortgage, and they are always amortized with the debt being repaid in regular payments over a specific period of time.
- The loan-to-value ratio for residential mortgages tends to be higher, often between 80% - 100%.
In commercial real estate sales, lenders research whether or not a property will bring in that revenue. To do this they often take into account the building’s previous financial statements, the loan-to-value ratio, the loan’s collateral, and the creditworthiness of the owners or sellers.
Though the primary goal of a mortgage is to secure a living space, the end goal of commercial real estate is to secure a revenue-generating property. Whether that means the building is purchased outright or a loan is taken out, lenders and investors are on the lookout for properties that will produce income.
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